Investors Willing to Take on More Risk

Here’s a thought exercise:

Imagine you have two stocks (let’s call them A and B) that are equal in every way. Both stocks are expected to earn $1 per share this year. However, there is one small difference. Stock A is expected to earn $1 per share, plus or minus two cents. Stock B is expected to earn $1 per share, plus or minus 20 cents.

So here’s the question: Which stock is worth more?

The answer is that in most instances, we can assume that stock A is worth more. On occasion, stock B might be worth more, but as a general rule, it will be stock A. The reason why is that investors hate losses more than they like gains. That’s a very important point in finance and in human nature in general.

As the two stocks trade, the gap between them will vary. The point I’ve been trying to make about Wall Street right now is that, in terms of this exercise, stock A is worth much, much more than stock B. This is due to the concerns that hit the market last year that sent investors rushing to “sure thing” investments.

The story for this year is that those concerns have been slowly melting away. In other words, stock B is closing the gap. Eric Falkenstein noted that low-vol strategies (which I have written about before) have been trailing the market this year.

Today is the first trading day of the second quarter and Wall Street just wrapped up its best quarter in over a decade. The Wall Street Journal writes today about the theme I’ve been harping on—that investors have willing to shoulder more risk.

Also reflecting the improved outlook, investors have scaled back holdings of high-quality, low-yielding government debt that had been a haven from last year’s turmoil. Willing to take on greater risks, and hungry for yield with interest rates locked at low levels, they have poured money lower-quality bonds, such as high-yield corporate debt.

Stock-market gains aside, capital markets have a more becalmed air than at the beginning of the year. One tell-tale sign of the more normal environment is that stocks are moving less in lockstep with other assets than during the second half of 2011.

Last year, in a reflection of extreme levels of uncertainty and worries about Europe, correlations between different investments hit historic highs. Riskier assets—including stocks, commodities or emerging market currencies—would either rally together on “risk on” trading on days where investors were confident, or sell off as worried investors rushed for safety when markets were in “risk off” mode.

This could be clearly seen in the tendency of the U.S. dollar and U.S. stocks to move in predictable fashion. When the dollar rose, stocks fell and vice versa. Historically, there has been no correlation between the two, reflecting the different nature of the two assets.

But when fears of a euro-zone breakup hit a fever pitch last November and December, stocks—seen as a risky investment—would move in the opposite direction of the dollar—seen as a haven—60% or 70% of the time.

Now that “inverse correlation” is down to around 30%, according to data from Macro Risk Advisors.

Related to this, volatility has dropped dramatically, The WSJ notes that in the fourth quarter, there were 14 daily moves of 2% or more. But in the first quarter of 2012, there were zero moves that dramatic.

I think it’s interesting that analysts have reversed course recently by raising full-year earnings estimates over the past month. In January and February, estimates had been coming down. The consensus now is that the S&P 500 will earn $104.37 this year. This means the stock market is 11% below the average P/E Ratio of the last 58 years.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

Named by CNN/Money as the best buy-and-hold blogger, Eddy Elfenbein is the editor of Crossing Wall Street. His free Buy List has beaten the S&P 500 seven times in the last eight years. (more)